Spend Like There Is a Tomorrow

As I write this article, I am having an outer body experience. I can swear I am in the midst of a Seinfeld episode. But...

By Susan L. Hirshman|April 01, 2008 at 04:00 AM

X

Share with Email

sending now...

Thank you for sharing!

Your article was successfully shared with the contacts you provided.

As I write this article, I am having an outer body experience. I can swear I am in the midst of a Seinfeld episode. But alas, the smell of cigars coming from one side of my chair doesn’t emanate from Kramer and the high-pitched cackling laughter from the other isn’t Estelle Costanza, and I am not in a Seinfeld episode at all. I am poolside in a retirement community in southern Florida.

I tried to keep my profession under wraps, but within five minutes my aunt told anyone and everyone that I was a “wealth management expert.”

You can imagine what happened–questions about the markets, their portfolios, and the economy started to come at me faster than a speeding bullet. The retirees’ concerns can be summed up in one word: volatility. Specifically they want to know what should they be doing today to protect their portfolio?

My diplomatic skills were tested here–because I wasn’t going to talk to them about stock tips, or what I see in my market crystal ball. What I was going to discuss with them was their spending policy. So I asked one simple and pointed question: What is your current spending policy? Believe it or not I did not get tomatoes thrown at me. Instead I got a bunch of confused looks. Finally, the man with the biggest (and smelliest) cigar of the group said, “Why is it your business?”

It is not only my business, but it should be the business of all advisors of current retirees. Why? Because a client’s spending rate is one the most critical drivers of a successful retirement in difficult markets. JPMorgan’s research suggests asset allocation alone may not prevent a significant decline in wealth. In fact, they found that a depleted initial investment followed by further withdrawals accelerated the decline. In an analysis that looked at 20-year time frames between 1926 and 2005, they found that the asset allocation mix actually had less impact on wealth preservation than the level of spending.

Are your clients too focused on performance and not enough on their spending? I would guess yes. According to a new survey SunLife, The Expense Reality, pre- and current retirees in their 50s thru 70s expect their expenses to go up, but they have no plan to cut back on leisure spending. Additionally, according to a report by Phoenix Affluent Marketing, 86% of millionaires surveyed expected their spending to remain the same or increase for the March-May 2008 time period. Furthermore, drug and medical expenses are said to be rising faster than inflation and a recent survey for the Employee Benefit Research Institute found that although 88% of prospective retirees expected to reduce their spending in retirement, only 45% actually did.

Know How Much You Spend

I found that most people determined their annual “spending policy” one of two ways–either they have a certain dollar amount in mind, or they spend a specific percentage of their portfolio each year (5% was the estimated average). Most people in this group used the specific dollar-spending plan, because to them it is very similar to getting a salary–something very familiar to them. Unfortunately, with this type of spending pattern one typically ends up overspending in bad years and underspending in good years.

When I probed further what I actually found is that most people, no matter how they say they determine their spending policy, were really unsure of the true amounts of spending. Many of the retirees in this group agreed that they were overspending without even knowing it. Therefore, in these questionable times it is imperative we as advisors get newer retirees to obsess about their spending with the same intensity as their portfolio performance.

The question that must be asked is this: “How much spending is right?” Obviously, the answer is dependant on their respective goals. It comes down to the tradeoff of lifestyle vs. legacy. What matters more to them–continuing to live exactly as they do now, or maintaining their wealth? If the answer is lifestyle, help them to understand that if they continue to spend at their current rate over the next 15 or 20 years what the probability is that they will outlive their assets. If their concern is legacy, you need to help them identify the spending rate that will give them real wealth preservation. Furthermore, it is crucial that you find out what their “number” is. Most people have an emotional asset “floor” which they do not want to go below. Having their assets dip below this number often drives them to some form or other of irrational behavior–which we know is the kiss of death to a successful retirement.

With the markets behaving as they are lately, caution with spending is called for in these early years of retirement. Excess money spent now will further diminish the value of the investment corpus, making it more difficult to catch up when markets recover. And if investors have to contend with poor markets and inflation in the early stages of a 20-year period, every incremental dollar of spending compounds the decline in the asset pool, potentially adding years to the period needed to recover the initial value of the corpus.

According to a study by the JP Morgan Private Bank, a spending target of 3% to 4% offered the best chance of preserving wealth, especially in equity markets growing by single digits. A 5% spending rate can be sustained only during bull markets. At a spending rate of 7%, their research suggests that a substantial drop in real wealth is almost inevitable.

A Conversation No One Wants To Have

I don’t have to tell you that this is a delicate conversation to have. Sitting down with your clients and helping them to determine how much they really are spending in many cases may be difficult–especially if a realistic spending amount was not determined before retirement.

Moreover, if a framework for assessing all the elements that determine what the appropriate level of spending is for the respective client was not done prior to their retirement (or even if it was), be prepared for a variety of emotional reactions. It may come as a shock to a retiree with a $5 million portfolio that they can only safely spend $150,000 to $200,000 (post tax) a year on living expenses, gifts, charity, and passions without eroding the value of their portfolio. If spending needs to be curtailed, you can really add value and get to truly understand what there priorities are by helping them to determine where the spending reductions may come from.

A caution for you here–it is very easy for you to become judgmental of their choices at this stage–so keep in mind their emotive values/buying behaviors not yours. If you need a refresher on buying behaviors, go back to my June 2006 column, “Listening to Margaret Mead.” Regular readers know I refer to this article often. I do it because understanding how your client thinks is the key to increasing your success. This may be a difficult truth for the newly retired to face–especially if they are on a spending spree and don’t want to “slow down” on new purchases. They may throw caution to the wind and spend what they want. You may not agree with their choice but it’s their choice as long as it’s done with a non-emotional, conscious recognition of the trade-offs involved.

While no one can predict the future, the need for informed decision-making and caution remains paramount. If the markets turn out to be better than expected, real wealth will naturally grow, and actual dollars distributed will be much greater than anticipated. If the markets are worse, then these retirees will at least have a relatively larger base from which assets can grow when strong markets return.

Building wealth is difficult, particularly when assets are withdrawn for spending. It may seem obvious, but too often it’s overlooked–if your client’s spending rate is too high, they will not be able to build wealth no matter how good your best investment strategy is.

Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached atsusan.l.hirshman@jpmorgan.com.

ThinkAdvisor

Free unlimited access to ThinkAdvisor.com which provides advisors, like you, with comprehensive coverage of the products, services and trends necessary to guide your clients in making critical wealth, health and life decisions.

Exclusive discounts on ALM and ThinkAdvisor events.

Access to other award-winning ALM websites including TreasuryandRisk.com and Law.com.